In finance and economics, a bond or debenture is a debt instrument that obligates the issuer to pay to the bondholder the principal (the original amount of the loan) plus interest. Thus, a bond is essentially an I.O.U. (I owe you contract) issued by a private or governmental corporation. The corporation "borrows" the face amount of the bond from its buyer, pays interest on that debt while it is outstanding, and then "redeems" the bond by paying back the debt. A mortgage is a bond with a lien on a real estate.
Bonds are securities but differ from shares of stock in that stock is an ownership interest (termed "equity"), but bonds are "debt": Therefore a shareholder is an owner, but a bond-holder is a creditor.
Each country sets its own rules for issuing and redeeming short and long-term debt and stock. In the U.S. (for example):
- Bonds are long-term loans secured by property rather than short-term loans secured merely by the debtor's promise to pay.
- Interest paid to bondholders receives preferential tax treatment compared to dividends paid to shareholders.
- In bankruptcy, bondholders are paid before short term creditors (including workers who are owed wages) and all creditors must be paid in full before owners receive anything.
Bonds are issued by governments or other public authorities, credit institutions, and companies, and are sold through banks and stock brokers. They enable the issuer to finance long-term investments with external funds. The term total volume refers to the number of individual bonds in a bond issue.
Features of bonds
The most important features of a bond are:
- initial value, known as the "par value"
- maturity date - Bond maturity tells when investors should expect to get the principal back and how long they can expect to receive interest payments. The maturity of a bond can be any length of time, although typical bond maturities range from one year to 30 years. There are three groups of bond maturities:
- Short-term (Bills): Maturities less than 1 year
- Medium-term (Notes): Maturities between 1 and 10 years
- Long-term bonds (Bonds): Maturities greater than 10 years. Most bonds are 30 years or less, but bonds have been issued with maturities of up to 100 years. Some bonds never mature (perpetuities).
- the "coupon" or "nominal yield," effectively the interest rate
- whether the interest rate is fixed or floating
- whether the lender can force the borrower to buy back the bond before maturity (which is often called an embedded put option).
- whether the borrower can pay back the bond at any time before the maturity date (which is called prepayment, or an embedded call option).
The rights of a particular bond issue are specified in a written document, called an "indenture". In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. Those terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bondholders.
Interest is paid on the first "coupon date" and subsequently on coupon dates at regular intervals, assuming the issuer has the money to make the payments on those dates. If all interest ("coupon") payments have not been made when due, and so are in arrears, the issuer must also pay those back-due amounts when it redeems the bond, in addition to the principal ("face") amount.
The bond may have a "call" provision that allows the issuer to pay back the debt (redeem the bond) before its nominal maturity date. When there is no such provision requiring a holder to let the issuer redeem a bond before its maturity date, the issuer may offer to redeem a bond early, and its holder may accept or reject that offer.
There are three broad categories of callable bonds.
- A "European callable", one with a European-style contract, can only be called on one specific date.
- A "Bermudan callable" can be called on several different dates (usually coinciding with coupon dates).
- A "US" or "American callable" can be called at any time until the option matures.
The European option can also be considered to be a type of Bermudan option, with only one call date.
Bonds can also carry "put options", which allow the investor to sell the bonds back to the issuer at par value on specified dates.
Types of bond
Convertible bonds or convertible debentures are those that can be converted into some other kind of securities, usually common stock in the corporation that issued the bonds.
Fixed-rate bonds, where the interest rate remains constant throughout the life of the bond.
- Floating-rate bonds , with a variable interest rate that is tied to a benchmark such as a money market index . The "coupon" is then periodically reset, normally every three or six months.
High-yield bonds are bonds that yield more than investment grade bonds. The usual reason a company has to pay more interest on their debt is that the company has poor credit rating, which means it is considered a high risk investment. Bonds with a poor credit rating are sometimes known as junk bonds. Junk bonds of companies that previously had higher credit ratings are sometimes known as fallen angels. Other companies have lower credit ratings because they are relatively unknown and haven't established enough of a track record to qualify for lower interest loans. Equity techniques are often used for the analysis of high-yield bonds, as they tend to share more characteristics than investment grade bonds. Different credit analysis techniques, such as researching the covenants of the bonds, are also considered much more important than with investment grade bonds.
Zero-coupon bonds, which do not bear interest, as such, but are sold at a substantial discount from their par value. The bondholder receives the full face value at maturity, and the "spread" between the issue price and redemption price is the bond's yield. (Series E savings bonds from the U.S. government are zero-coupon bonds.) Zero-coupon bonds may be created from normal bonds by finance institutions "stripping" the coupons (the interest part of the bond) from them - that is, they separate the coupons from the principal part of the bond and sell them independently from each other.
Inflation-indexed bonds, in which the principal (or "face" value) is indexed to inflation, which causes higher interest payments (interest is calculated as the coupon rate multiplied by the principal amount). TIPS (Treasury Inflation-Protected Securities) and I-bonds are examples of inflation indexed bonds issued by the U.S. government.
Securitized bonds whose interest and principal payments are backed by an underlying cash flow from another asset. For example, if a credit card company needs immediate cash to lend to credit card holders, they can issue a bond that is backed by the credit card payments. Another large market of securitized bonds are mortgage backed debt.
- Subordinated bonds are those that have a lower priority than other debts of the issuing corporation, so if there is not enough money to pay all the company's debts, the "senior" (higher-priority) bonds are paid first, and the subordinate bonds are paid out of what money, if any, is left. These priority levels are called 'tranches', and many bonds have more than two. In some cases, the tranches don't determine whether a bond holder will be paid, but rather how fast they will be paid. For example, if the bond is a mortgage, the senior tranche might receive any funds that are prepaid by the debtor.
- Perpetual bonds are also often called annuities. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. They have no maturity date and still trade today despite, for example, dating to 1888 for the specific Consols known as the Treasury 2.5% Annuities. The concept of perpetual bonds also serves a useful purpose in that it represents an extreme case of a bond having only a cash flow and no re-payment of principal, being the theoretical opposite in many ways of a Zero-coupon bond which has no cash flow during the life of a bond and has only a re-payment of principal against a purchase price at a discounted par value. Perpetual bond concepts thus serve an extremely useful purpose, along with Zero-coupon bond concepts, for estimating the volatility of many other bond types having characteristics falling between the extremes of perpetual bonds and Zero-coupon bonds under conditions of variable yields, variable maturity dates, and variable basis point shifts that may occur during the life of a bond.
Trading and valuing bonds
The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. Since these factors are likely to change over time, the market value of a bond can vary after it is issued.
The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.
The market price of a bond may include the accrued interest since the last coupon date (some bond markets include accrued interest in the trading price and others add it on explicitly after trading). The price including accrued interest is known as the "flat" or "tel quel price ". (See also Accrual bond.)
The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).
Taking into account the expected capital gain or loss (the difference between the current price and the redemption value ) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve.
Investing in bonds
Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through mutual funds. Still, in the U.S., nearly 10 percent of all bonds outstanding are held directly by households.
Bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid -- it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks -- and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back, whereas the company's stock often ends up valueless. However, bonds can be risky:
- Bonds incur interest rate risk, meaning they will decrease in value when the generally prevailing interest rate rises. This happens to all fixed-rate bonds, no matter what company or government issues them. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere -- perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds.
However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify bond risk is in terms of its duration.
- Bonds can become volatile if one of the bond rating agencies like Standard and Poor's or Moody's upgrades or downgrades the credit quality of the issuing company or government. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not impact the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
- A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of the United States and many other countries, bondholders are in line to receive the proceeds of the sale of the assets of a bankrupt company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar.
- Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond at once. This creates reinvestment risk , meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when rates are falling.
Arguments against bonds
Some theories of economics, notably Islamic economics and green economics, argue that the overall impact of any debt on ecosystems and society is so negative that no bond should have any legal status. These theories are part of a broader category called creditary economics. In these, there is no creditor, only a joint venture partner or investor. Remnants of this same belief still exist even today in Western finance and legal precedents, as seen in usury laws, mortgage laws, and also as seen in perpetual bonds . At the time of issue during the late Middle Ages, many perpetual bonds were sold not as debt instruments but rather as an income stream or annuity instrument. One was buying a future income, not lending money. By this thinking, no interest was paid on perpetual bonds, despite the existence of a yield for such financial instruments.